This column, first published 15 December 2009, shows the main outlines of the crisis were clear months ago and suggests actions that – had they been taken early – would have mitigated problems facing the Eurozone today. The column concludes: "All this leads to the conclusion that the Eurozone governments should make clear where they stand on this issue. Not doing so implies that each time one member country gets into financial problems the future of the system is put into doubt." If only those words had been heeded months ago.

The Greek crisis has led to fears that this is only the beginning of a deeper sovereign debt crisis that could ultimately destabilise the Eurozone. Are these fears exaggerated? How to deal with these problems? These are some of the questions many observers have been asking themselves.

Origins of the present crisis

It is useful to start out with the origins of the present crisis. Figure 1 provides a useful way to organise our thoughts. It shows the average yearly changes (in percent of GDP) of private and public debt in the Eurozone.

The period 1999-2009 has been organised in periods of booms and busts: the boom years were 1999-2001 and 2005-07; the bust years were 2002-04 and 2008-09.

One observes a number of remarkable patterns.

First, private debt increases much more than public debt throughout the whole period (compare the left hand axis with the right hand axis).

Second, during boom years private debt increases spectacularly.

The latest boom period of 2005-07 stands out with yearly additions to private debt amounting on average to 35 percentage points of GDP.

During these boom periods, public debt growth drops to 1 to 2 percentage points of GDP. The opposite occurs during bust years. Private debt growth slows down and public debt growth accelerates.

Again the last period of bust (2008-09) stands out. Public debt increases by 10 percentage points of GDP per year, mirroring the spectacular increase of private debt during the boom years (but note that the surge of public debt during the bust years of 2008-09 are dwarfed by the private debt surge during the preceding boom years).

Figure 1

Source: ECB, Quarterly Euro Area Accounts. Note: 2009 is until second quarter

The following picture emerges. During boom years the private sector adds a lot of debt. This was spectacularly so during the boom of 2005-07. Then the bust comes and the governments pick up the pieces. They do this in two ways.

First, as the economy is driven into a recession, government revenues decline and social spending increases.

Second as part of the private debt is implicitly guaranteed by the government (bank debt in particular) the government is forced to issue its own debt to rescue private institutions.

Thus the driving force of the cyclical behaviour of government debt is the boom and bust character of private debt. This feature is particularly pronounced during the last boom-bust cycle that led to unsustainable private debt growth forcing governments to add large amounts to its own debt.1

Is the public debt sustainable?

Financial markets now ask the question of whether the addition of government debt is sustainable. Clearly the rate of increase of the last two years is unsustainable. But with Eurozone government debt standing at 85% of GDP at the end of 2009, the Eurozone is miles away from a possible debt crisis.

Things are different in some individual countries, in Greece in particular, a country with a weak political system that has been adding government debt at a much higher rate than the rest of the Eurozone and that in addition has a debt level exceeding 100% of GDP. So, while the Eurozone as a whole is no closer to a debt crisis than is the US, some of its member states have been moving closer to such a crisis.

Is it conceivable that a debt crisis in one member country of the Eurozone triggers a more general crisis involving other Eurozone countries? My answer is that yes, it is conceivable, but that it can easily be avoided.2

A debt crisis is conceivable

Let’s start with the first part of the answer: It is conceivable. Financial markets are nervous and the most nervous actors in the financial markets are the rating agencies. One thing one can say about these institutions is that they systematically fail to see crises come. And after the crisis erupts, they systematically overreact thereby intensifying it.

This was the case two years ago when the rating agencies were completely caught off guard by the credit crisis. It was again the case during the last few weeks. Only after Dubai postponed the repayment of its bonds and we had all read about it in the FT, did the rating agencies realise there was a crisis and did they downgrade Dubai’s bonds.

Credit rating agencies playing catch-up

Having failed so miserably in forecasting a sovereign debt crisis, they went on a frantic search for possible other sovereign bond crises. They found Greece, and other Eurozone countries with high budget deficits, and started the process of downgrading. This in turn led to a significant increase in government bond rates in countries “visited” by the agencies.
Add to this that the ECB is still using the ratings produced by the same agencies to accept or refuse collateral presented by banks in the Eurozone, and one can see that all the elements are in place to transform a local crisis into a crisis for the system as a whole.

A systemic crisis can be avoided

It does not have to be that way, however. A systemic crisis can be avoided. Let’s start with Greece again. Although an outright default by the Greek government remains a remote possibility it is good to think through what the other Eurozone countries can and will do in that case. They can easily bail out Greece. It does not cost them that much. In the unlikely event that Greece defaults on the full amount of its outstanding debt, a bail-out by the other Eurozone governments would add about 3% to these governments’ debt – a small number compared to the amounts added to save the banks during the financial crisis.

A Eurozone bailout is likely

The other Eurozone governments are also very likely to bail out Greece out of pure self-interest. There are two reasons for this.

First, a significant part of Greek bonds are held by financial institutions in Eurozone countries.

These institutions are likely to pressure their governments to come to their rescue.

Second, and more importantly, a failure to bail out Greece would trigger contagious effects in sovereign bond markets of the Eurozone. Investors having lost a lot of money holding Greek bonds would likely dump government bonds of countries, like Spain, Ireland, Portugal, Belgium that they perceive to have similar budgetary problems.

The local sovereign debt crisis would trigger an avalanche of other sovereign debt crises. I conclude that the Eurozone governments are condemned to intervene and to rescue the government of a member country hit by a sovereign debt crisis.

Are bailouts illegal?

It is sometimes said that bail-outs in the Eurozone are illegal because the Treaty says so (see Wyplosz 2009 on this). But this is a misreading of the Treaty. The no-bail-out clause only says that the EU shall not be liable for the debt of governments, i.e. the governments of the Union cannot be forced to bail out a member state. But this does not exclude that the governments of the EU freely decide to provide financial assistance to one of the member states. In fact this is explicitly laid down in Article 100, section 2.3

Eurozone governments have the legal capacity to bail out other governments, and in my opinion they are very likely to do so in the Eurozone if the need arises.

Financial markets today do not seem to believe this conclusion. If they did, they would not price the risk of Greek government bonds 250 basis points higher than the risk of German government bonds. The scepticism of the financial markets has much to do with the poor communication by the EU-authorities that have given conflicting signals about their readiness to give financial support to Greece if a sovereign debt crisis were to erupt.

Conclusion

All this leads to the conclusion that the Eurozone governments should make clear where they stand on this issue. Not doing so implies that each time one member country gets into financial problems the future of the system is put into doubt.

1 For a fascinating historic analysis of public and private debt see Reinhart and Rogoff(2009).
2 See also Eichengreen(2007) on this issue.
3 Here is the text: “Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, acting by a qualified majority on a proposal from the Commission, may grant, under certain conditions, Community financial assistance to the Member State concerned”.